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Lessons from DOJ Prosecution of Tony Hu for Sales Tax Fraud

December 6, 2016 – ArticlesLaw360By Matthew D. Lee

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On Oct. 18, 2016, a federal judge sentenced a well-known Chicago restaurant owner to prison for carrying out an extensive scheme to avoid paying state sales tax collected from customers of his establishments. Two important lessons may be drawn from this criminal case. First, criminal prosecutions of business owners for avoiding payment of state sales tax, which historically have been pursued by state authorities under state law tax statutes, may now be brought by federal prosecutors using the federal fraud and money laundering statutes. Second, the sentence imposed reflects the growing tendency of judges to impose sentences in tax cases that are below the applicable range as calculated under the United States Sentencing Guidelines.

Factual Background

The defendant in the case, Hu Xiaojun (also known as Tony Hu), owns and operates nine restaurants in the Chicago area. He was charged with federal wire fraud and money laundering offenses arising from his failure to pay sales tax to the state of Illinois on nearly $10 million in cash transactions occurring at his restaurants over a four-year period. Earlier this year, Tony Hu pleaded guilty to one count of wire fraud and one count of money laundering.[1]

According to the guilty plea agreement, between January 2010 and September 2014, the defendant failed to pay sales tax on transactions in which customers paid cash. To conceal cash sales, he instructed restaurant managers and employees to provide him with daily summaries of restaurant sales, which he would in turn alter to conceal cash sales. Hu and others would destroy the daily summary reports and cash transactions receipts, replacing them with incorrect reports that omitted the bulk of each restaurant’s cash sales. To hide cash sales from the state tax authorities, the defendant instructed employees to withhold cash generated from the restaurants from the corporate bank accounts to avoid creating financial records for those cash sales. Specifically, the restaurants in question discarded cash receipts until the reported amount was approximately 15 to 20 percent of credit card sales. The “discarded” cash was used to pay restaurant employees and suppliers without recording those expenses in the corporate books and records. The defendant also deposited a portion of the cash into his personal bank account, which he then used to pay personal expenses.

During the 2010 to 2014 time period, Hu instructed others to submit fraudulent sales figures to the Illinois Department of Revenue on monthly sales tax returns. Each month, the defendant directed his employees to provide false sales figures to his accountants, who in turn provided those figures to the state. In all, the defendant underreported his sales to the state by nearly $10 million, resulting in his underpayment of sales taxes by more than $1.1 million.

The wire fraud charge to which the defendant pleaded guilty is based upon his sending of an email containing false sales figures for the month of May 2014. The money-laundering charge to which the defendant pleaded guilty is based upon a series of financial transactions that he conducted using proceeds of his scheme to defraud the Illinois Department of Revenue. Specifically, the defendant deposited over $72,000 in cash into his personal bank account, which he knew consisted of funds derived from cash sales at his restaurants that were concealed from the state tax authorities. The defendant thereafter withdrew $60,000 from that account and purchased an official bank check, which he then deposited into a different business account. The defendant used the funds in that second bank account to purchase a restaurant and equipment, which he subsequently operated.

Sales Tax Fraud: No Longer Just a State Crime

At first glance, the facts of United States v. Xiaojun read like a typical criminal tax case and include the all-too-common attributes of tax fraud in the restaurant industry: the concealment of cash sales and the use of diverted cash to pay employees, purveyors and personal expenses of the restaurant’s owners. Indeed, the Justice Department’s website is replete with press releases announcing criminal tax charges against restaurant owners who engaged in conduct similar to that of this defendant, mostly commonly filing of false income tax returns in violation of 26 U.S.C. § 7206 or tax evasion in violation of 26 U.S.C. § 7201.

What makes United States v. Xiaojun notable is that the Justice Department did not assert a single federal tax charge against the defendant. The defendant’s payment of his employees in cash alone could have led to employment tax-related charges. Instead of charging Title 26 offenses, the government transformed what otherwise appears to be a garden-variety criminal tax case into a wire fraud and money laundering case by focusing on the defendant’s failure to pay state sales taxes.

The government’s case against Hu was premised upon a Justice Department policy titled Tax Directive No. 128, “Charging Mail Fraud, Wire Fraud or Bank Fraud Alone or as Predicate Offenses in Cases Involving Tax Administration.” This directive provides federal prosecutors with significantly expanded authority to use the mail and wire fraud statutes to charge additional crimes, and seek correspondingly increased penalties, in tax-related cases. Under a preceding policy, prosecutors were generally not permitted to use the fraud statutes where the use of the mails or wires was only incidental to a violation arising under the Internal Revenue laws.

Tax Directive No. 128 now authorizes prosecutors to use mail and wire fraud offenses and, more importantly, state tax violations where the mails or wire communication facilities are used, to transform cases that traditionally would be prosecuted under the tax laws into fraud and money laundering prosecutions. By charging mail and wire fraud in tax cases, the government can significantly change the charging and plea bargaining process. The mere threat of a mail fraud or money laundering charge may well cause targets of government investigations to plead guilty more willingly, and to agree to cooperate against other targets, than would have been likely under the prior policy where the charges were likely limited to federal tax offenses absent exceptional circumstances. In addition, the ability to include mail or wire fraud charges in a tax-related case provides prosecutors with an additional tool not previously available in traditional tax cases — the ability to seek forfeiture of the proceeds of the fraudulent scheme.

By relying upon the authority conferred by Tax Directive No. 128, the government can significantly ratchet up the pressure on targets of criminal tax investigations. By bringing charges under Title 18 rather than Title 26, the government can seek a longer prison sentence: the statutory maximum sentences available for mail fraud and money laundering, 20 years each, are significantly higher than the statutory maximum sentences available for tax fraud or tax evasion, which are three years and five years, respectively. In addition, the U.S. Sentencing Guidelines for mail fraud and money laundering crimes typically call for longer sentences than those applicable to tax offenses.

Charging mail fraud and money laundering also enables the government to seek restitution to be paid to the state agency that was defrauded. Had the government only charged federal tax crimes under Title 26, restitution could only have been ordered to the Internal Revenue Service. The government is also able to seek forfeiture of the funds that constitute proceeds of the mail fraud and money laundering offenses, an additional punishment that is not available for tax offenses. As part of his plea agreement, Hu agreed to pay at least $1 million in restitution to the Illinois Department of Revenue and to entry of a forfeiture judgment in an amount to be determined by the court at sentencing.

United States v. Xiaojun illustrates well how Tax Directive No. 128 provides federal prosecutors with significantly more leeway in charging offenses in what are viewed as traditional tax cases. No longer confined to the criminal offenses enumerated in Title 26, federal prosecutors can significantly increase the pressure on defendants by charging mail fraud and money laundering, seeking longer sentences and extracting substantial financial penalties by requiring defendants to pay both restitution and forfeiture. Prosecuting state sales tax fraud is no longer the exclusive domain of state authorities.

As a result of his guilty plea, Hu was facing a possible prison sentence of 41 to 51 months as calculated under the applicable Sentencing Guidelines. Since the Supreme Court ruled in United States v. Booker, 543 U.S. 220 (2005), that the sentencing guidelines are no longer mandatory and binding, the applicable guideline range is but one of numerous factors that sentencing judges must consider in fashioning an appropriate sentence pursuant to 18 U.S.C. § 3553(a). Other considerations are the nature and circumstances of the offense and the history and characteristics of the defendant. After taking account of these factors, as well as the advisory guidelines range, the sentencing judge imposed a significantly below-guideline sentence, of one year and a day. With credit for good-time served, Hu will likely serve only 10 and one-half months in prison.

Far from aberrational, the sentence imposed on Hu fully comports with recent trends in tax fraud cases. According to the United States Sentencing Commission, in fiscal year 2015, 648 offenders were sentenced for tax fraud offenses.[2] Nearly two-thirds of those defendants were sentenced to imprisonment, with the average sentence being 17 months in jail. However, nearly half of those offenders received a sentence below the applicable Sentencing Guidelines range. And the percentage of below-range sentences — commonly referred to as “downward variances” — is steadily increasing, from 41.8 percent in FY 2011 to 49.2 percent in FY 2015. The average sentence for tax offenders has also decreased over the past five years.

Notably, the Northern District of Illinois — the judicial district in which Hu was prosecuted — had the most tax prosecutions of any district in the United States during FY 2015. That district also served as the venue for one of most significant downward variances in a tax case ever granted by a district court judge. In United States v. Ty Warner, the defendant pleaded guilty to evading about $5.6 million in federal income taxes.[3] Warner, who gained fame as the creator of the Beanie Baby toys, had secret Swiss bank accounts in which he hid over $100 million. Based upon the amount of taxes evaded, Warner faced a sentence of 46 to 57 months under the sentencing guidelines. Notwithstanding the significant tax loss, the district court judge imposed a sentence of probation — a downward variance of virtually unheard-of magnitude — based upon what it considered to be an exemplary lifetime of charitable good works by Warner as well as the fact that the defendant was a first-time offender who posed a low risk of recidivism.

The sentencing judge’s decision to grant a substantial downward variance to Hu was undoubtedly influenced by several important considerations. By pleading guilty, the defendant accepted responsibility for his misconduct — always an important factor at sentencing — but demonstrated further acceptance by making full restitution to the state of Illinois of all sales taxes evaded, nearly $1.1 million, prior to sentencing. In addition, the judge ordered Hu to annually perform 200 hours of community service for two years following his release from prison, reflecting a growing judicial trend toward considerations of alternatives to incarceration.

Conclusion

Two important lessons can be learned from the government’s case against Hu. First, the prosecution of sales tax fraud no longer falls solely within the purview of state authorities. Tax Division Directive 128 permits federal prosecutors to charge mail fraud, wire fraud, and even money laundering based upon a scheme to avoid paying state sales tax, exposing a culpable business owner to significantly longer jail sentences than could result from prosecution by state prosecutors under state law tax statutes. Second, below-guideline range sentences continue to be a feature that distinguishes tax cases from other white collar offenses. Nearly half of all tax offenders receive a sentence below the applicable range specified in the Sentencing Guidelines. This trend may be attributable to the view, held by some, that tax crimes are less serious than other types of white collar offenses, or to a general distaste for the formulaic approach to sentencing reflected in the Sentencing Guidelines, or both. In any event, tax offenders who accept responsibility for their misconduct by pleading guilty and making full restitution, and who have otherwise lived a commendable life and been productive members of society, can take comfort in the fact that their odds of receiving a below-range sentence are favorable, even if they are charged with fraud or money laundering offenses rather than straightforward tax charges.

Reprinted with permission from Law360. (c) 2016 Portfolio Media. Further duplication without permission is prohibited. All rights reserved.